January 24, 2014

Lessons from Asia in Financial Development

Hugh Patrick discusses the liberalization of financial systems behind the remarkable economic development of China, Japan, and Korea.


In this article the name Korea refers to the Republic of Korea, often referred to as South Korea. - Ed.

Why write this book? 
Professor Yung Chul Park of Korea University and I had produced a similar book about Japan, Korea, and Taiwan over two decades ago, looking at financial development’s relationship to the economic growth of these three countries, which was happening rapidly in the modern period up to about 1990. He suggested we write an update that would look at the last 20 years and include mainland China, about which there’s almost no literature. As before, we agreed I would do an overview chapter and edit all the chapters, he would do the Korea chapter, and we would recruit Edward Lincoln to do the Japan chapter and Yiping Huang the China chapter.

But this is not a technical book for econometricians. It is designed for anyone interested in these economies and in understanding their financial systems.

Why these three countries — and why not Taiwan this time around?
Taiwan is another successful story, but we prioritized looking at China, where, as I noted, there’s a real void. We decided China would be more immediately relevant for readers.

One question I asked myself was, what’s the essence of these three countries? It’s not simple geography. It is that the three nations are case studies of very successful catch-up growth and successful financial development, though with many twists and turns. These are cases of extraordinary success. We talked for the last decade about Asia being a key part of growth in the world now, and we’ll probably talk about that for the next decade.

Each of these nations is obviously unique, but is there any underlying pattern you can point to that characterizes the development of their financial systems?
Of course there are always political and economic constraints. There are always vested interests in the status quo. Every nation has to overcome those. But for these nations, there was an acute sense of pressure in that they were quickly facing a more global financial system, one that was becoming less domestic and regional.

All of these countries in the early postwar period had very repressed financial systems. That is not unique to China, which people tend to forget. All of them had interest rate controls, credit allocation controls, and ownership controls, and their markets functioned nothing like what we think of as markets working.

However, by the 1980s global financial markets had become well developed, with some banks and other financial institutions as major global players. Money flows were vibrant, particularly in short-term markets, but also through foreign direct investment and bond markets. All three of these countries felt tremendous pressure, both domestic and foreign, to take advantage of lower interest rates, better access to capital, and new financial technologies. The liberalization process gradually loosened controls, and you saw tremendous economic growth in Japan and Korea. By 1990 Japan had become very liberalized and Korea was fairly far along by then as well.

China was an outlier because of its socialist system and, in particular, because the government owned the financial system, including all banks. One thing we found is that China is currently about halfway to what we would call a highly liberalized financial system. It took 30 years to go halfway; it will probably go the rest of the way much sooner, though not immediately.

Why do you see Korea as such an interesting case?
South Korea is an economy that has grown very rapidly and very successfully and has made this transition from being an authoritarian state to becoming a democratic state peacefully. In that sense it’s one of the most successful stories there is. It’s a different one from Japan, which was defeated and occupied. It’s a different one from China, which remains an authoritarian socialist state with market characteristics.

Korea is now regarded as one of the advanced middle-power countries. That’s really quite an impressive performance for a country that was an agricultural colony, then had a war, and was divided.

Japan shares many of the features of European Union countries. What would you say are the key lessons they offer each other?
In the sense that Japan and the European Union countries are high income and developed and have similar problems, and Japan is somewhat of a frontrunner, Europe can look to Japan to see the kinds of problems it might face. The most important is Japan’s advanced stage in the demographic transition. Japan’s working-age labor force peaked in the 1990s, its population is rapidly aging, and the population is now decreasing. Europe is now starting to experience those same demographic trend realities.

One big lesson for Asian economies is that trying to set up a single currency and a set of rules that bring together diverse countries doesn’t work very well. You need a really strong political reason for doing it. That doesn’t exist in Asia, and even though the will did exist somewhat in Europe, it hasn’t always worked out well. Look what happened with Greece: a lot of its debt was held by institutions in Europe. Although it’s the same Euro currency, those institutions have much less desire to protect some weak bank in a foreign country than they would have for a bank in their own country — even though they’re in a so-called common eurozone or European community. Whereas in Japan, while the government debt is huge, it is held primarily by Japanese institutions and individuals, not foreigners.

As you looked at the histories and patterns in each country, were there any surprises?
It’s surprising how complex the interactions are and how hard it is to tease out the interactions between the financial systems and corporations in the real economy. Economists are still trying to figure out how to understand that dynamic.

I knew that Japan had tried very hard to liberalize, deregulate, and develop a bond market beginning around 1990, but that in 2010 it remained essentially a banking system. We spelled that out in rather stark terms in the Japan chapter in a way that was nevertheless striking to me. Seeing that companies weren’t going out and issuing bonds — the degree to which Japanese firms just went to their bank and borrowed more money if they needed it — was striking. Companies haven’t taken advantage of market-based finance — neither long-term bonds nor shorter-term corporate instruments have developed very much in Japan. So one big question that came out of the book for me was, what are the domestic real investment opportunities in Japan? I am not convinced the basic problem is the lack of finance even though, not surprisingly, some small companies complain about lack of access to finance. I think that is a problem of evaluating creditworthiness, certainly not unique to Japan.

I was surprised to find that Yung Chul and I disagreed somewhat on Korea! He takes a much more nuanced and skeptical view of the process of deregulation than I do. He thinks there were times when it went too far too soon.

On a similar note regarding China, I was surprised to see Yiping Huang, who wrote the chapter on China, assert that financial repression in the 1980s and 1990s was not so bad. I’d always believed that financial repression was inefficient at allocating resources. To have him say that given the context — a controlled economy with state ownership and government control — China needed to open its financial system more slowly before it started to liberalize tempered my thinking.

Hugh Patrick is the Robert D. Calkins Professor of International Business Emeritus, director of the Center on Japanese Economy and Business at Columbia Business School, and co-director of the APEC Study Center at Columbia University.

Read an excerpt from the book at Columbia University Press.

Read the Research

Hugh Patrick, Yung Chul Park

"How Finance Is Shaping the Economies of China, Japan, and Korea"

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